Time-varying risk preference and equity risk premium forecasting: The role of the disposition effect

Abstract

This study examines whether the disposition effect can explain time-varying risk preference and predict the equity risk premium. To do so, we propose an augmented general autoregressive conditional heteroskedasticity (GARCH)-in-Mean model unraveling the complex relationship between unrealized gains/losses, realized returns, and the equity risk premium. In our model, the risk aversion coefficient varies with the market state of unrealized gains/losses. Using data from the US stock markets, we show strong evidence that the disposition effect drives time-varying risk preference: The risk aversion coefficient is significantly positive during periods of unrealized gains, but insignificant during periods of unrealized losses. These findings reconcile the conflicting results of the risk-return trade-off in existing literature. Moreover, our model shows significant predictability of the equity risk premium, both in-sample and out-of-sample. Incorporating our model's predictions can yield substantial utility gains for a mean-variance investor. Our results indicate that the disposition effect leads to time-varying risk preference and thus induces equity risk premium predictability.